An ambitious overhaul of India’s confusing hotch-potch of indirect taxes could give business a boost

TO MANY Indians the tendu leaf is a source of comfort. Hand-picked, dried then dampened, the leaf is rolled into the beedis, or cigarettes, that glow in India's winter gloom. But the leaf is also a small example of India's fiscal fragmentation. In the state of Rajasthan and many others, the state government charges a value-added tax (VAT) of just 4% on the leaf, deeming it an essential good. In Uttarakhand, the government charges the standard rate of 12.5%. In Madhya Pradesh, meanwhile, leaf-rollers must pay a hefty 25.3%.

India's appeal to business rests on the potential size of its market: over 1 billion consumers, spending about $600 billion a year. But viewed through a fiscal lens, the country is not one market, but 28 states, each with its own tax-raising powers, which they are not afraid to use.

In its election-winning manifesto, India's Congress party vowed to “create a seamless national common market for our farmers, artisans and entrepreneurs”. It would achieve this feat by introducing a nationwide Goods and Services Tax (GST), subsuming most of the hotch-potch of indirect taxes imposed by the states and the central government. The GST could be the “single most important initiative in the fiscal history of India”, argue Satya Poddar of Ernst & Young and Ehtisham Ahmad of the London School of Economics.

The government had hoped to introduce the tax by April 2010. But before it can do so, it must secure the agreement of the states, which prize their fiscal autonomy, and an amendment to the constitution, which details who gets to tax what.

The constitution specifies that India's states can tax goods, such as tendu leaves, but not services, which are the preserve of the central government. The centre can also impose “excise” duties on goods at the point of manufacture, but not further downstream—a relic of the days when an unsophisticated state found it easiest to tax commodities as they left the factory gate. Thus, under India's peculiar separation of fiscal powers, the states cannot tax services and the central government cannot tax goods beyond their source. The GST, in contrast, would allow the two levels of government to tax both goods and services at each link in the value chain.

This is not quite an act of fiscal unification. The centre and the states will set their rates separately. The states also want the freedom to exempt some politically sensitive items and tax others at a discounted rate. But a report published on December 15th by the finance commission, which brokers fiscal compromises between the centre and the states, argues vehemently against such fiddling. It calls for a “flawless” GST, imposing a flat rate of 7% for the states and 5% for the centre, with few if any exceptions. It would rather delay the GST by six months than risk birth defects that would be hard to fix later.

Even if it retains a few flaws, the GST will be far simpler than the thicket of taxes, surcharges and cesses it will replace. Gone will be the state levies on entertainment and gambling, as well as the centre's “additional excise duty”, “additional customs duty” and its close relation, “special additional duty”, otherwise known as SAD.

This rationalisation promises a number of benefits for businesses and taxmen alike. It would stop the squabbling over what counts as manufacturing (and so is subject to excise) and what counts as a service (and can therefore escape state VAT). The GST would also spare Indians from paying a “cascade” of taxes on taxes. Accountants, for example, pay state VAT on their physical inputs, such as pens and paper. But because accountancy is a service, they do not collect VAT on the fees they charge. That means they cannot offset the VAT they pay against VAT they charge. Instead the tax on their inputs is hidden in the price of their services.

This hidden tax adds to the costs of any manufacturer hiring an accountant. When the manufacturer sells its wares, it must charge VAT on the price of the goods, which includes the taxes hidden in the services required to make them. “My gut feeling is that 35-40% of the indirect taxes collected by the centre and the states is due to cascading,” says Mr Poddar.

The worst expression of India's fiscal fragmentation is the central sales tax (CST), which is set by the centre but collected by the states. When a company sells its products across state borders, the purchaser must pay VAT in the state where the goods are bought. But the seller must also pay CST in the state from which the goods are supplied. This double taxation is the most egregious impediment to India's single market. The CST has already been cut from 4% to 2%. The advent of GST provides a chance to abolish it altogether.

The GST should also reduce the ruinous delays and corruption at India's border checkpoints, the visible seams in India's economic union. These are supposed to deter tax evasion, but in practice they allow corrupt inspectors to charge unofficial taxes of their own. According to a recent report by the Transport Corporation of India and the Indian Institute of Management, Calcutta, a lorry can waste 32 hours at various checkpoints on the route from Kolkata to Mumbai.

The new tax, however, should be self-enforcing across borders, since firms cannot offset the taxes they have paid on inputs if their supplier has not declared them. Moreover, the central GST will serve as a cross-check on the patchwork of state GSTs, since the states and the central government should tax the same number of transactions nationwide. State governments are still insisting that they will need checkpoints, to hunt for illicit goods and to inspect the roadworthiness of vehicles, among other things. So disconsolate lorry drivers will, alas, still be stuck by the roadside smoking low-tax beedis.